FDI and domestic investment

In both the wage and employment regressions, FDI is included on its own as well as part of gross investment in order to separate the effects of FDI as a distinctive form of investment – one that may tend to pay higher wages or create more (or less) employment than other forms. But in order to fully appreciate its role, the relationship between FDI and domestic investment must be investigated, as it is not necessarily the case that FDI merely adds to labor demand as a part of gross investment.

FDI might encourage or crowd in domestic investment, as when there are strong backward or forward linkages created by new foreign firms. Or, FDI could crowd out domestic investment, as when foreign firms compete with domestic firms and drive them out of business. Using panel data for the period 1970-96 in three developing regions, Asia, Africa and Latin America, Manuel Agosin and Ricardo Mayer (2000) did an econometric study of whether foreign investment crowds in domestic investment. Their results indicate that in Asia, and to a lesser extent in Africa, there has been strong crowding in of domestic investment by FDI. In Latin America, FDI has had a strong crowding out effect.

China is one of the countries in their study, and they find that FDI has had a “neutral” effect on domestic investment; that is, it has neither crowded in nor crowded out domestic investment. One problem with this study for China is the time period under consideration.

China did not allow FDI until 1979, and even then policy restrictions were strict until the mid-1980s, so the China results deserve closer analysis. In terms of this type of work on China, Haishun Sun (1998) does a simple regression analysis of the determinants of domestic investment in ten coastal provinces between 1983 and 1995, when about 90 percent of FDI targeted China’s coastal region. Using income per capita (as a proxy for domestic savings), FDI, and other forms of foreign capital, he finds a strong significant positive correlation between FDI and domestic investment. Such a simple approach is unconvincing, however, as the problem of omitted variables (such as measures of policy) throws the causal link between FDI and domestic investment into serious question. Among qualitative studies of the relationship between FDI and domestic investment in China, the sentiment is less sanguine than Sun’s.

Yasheng Huang (1998) argues that FDI probably crowds out domestic investment because FIEs tend to be highly leveraged and compete with local firms for domestic bank financing. This leveraging is a direct result of policy incentives that grant preferred status to FIEs – Chinese partners are more motivated to qualify for FIE status than to ensure adequate financial contributions from foreign partners. Thus the equity contribution by foreign investors often falls short of what is specified in the contract, and Chinese partners end up borrowing to cover the shortfall (Huang 1998).

And Nicholas Lardy, in a classic analysis of China’s economic reform process, claims that rather than financing increased levels of investment, China’s substantial capital inflows have been used for three other purposes: (1) to increase the foreign exchange holdings of China’s Central Bank, which in the three years between 1994 and 1996 increased by US$83. 3 billion, and in 1997 by US$35 billion; (2) to provide funds for capital flight;11 and (3) to a much lesser extent, to finance investment abroad by Chinese firms (Lardy 1998: 191-92).